May Agency MBS Update

Monthly Commentary

Agency MBS performance was slightly negative in May as gathering global storm
clouds cast a long shadow over the market. The first part of the month was
characterized by higher interest rates, the result of increasing optimism in the pace
of U.S. growth. At 4.86%, 30yr mortgage rates reached their highest level since
2011. Stocks rallied as volatility fell, benefitting agency MBS investors. However, the
positive excess returns were not destined to remain through month end. Confidence
in emerging markets and belief in the strength of European data eroded in the last
two weeks of the month. Political turmoil in Italy roiled global markets while 10yr
U.S. Treasury yields rallied from 3.11% to 2.86% over the final two weeks of May.
Volatility spiked to the highest level witnessed since February, as concern percolated
across the globe. While earlier in the year agency mortgages traded better when
conditions indicated that interest rates would remain low for a longer period, the
script was flipped somewhat throughout May. While extension is not beneficial for
mortgage investors, previous duration extension in the MBS Index reduced the
perils of slightly elevated interest rates. So long as the macro picture buoys risk
markets and keeps volatility near historically low levels, slower prepayment speeds
associated with higher rate levels could benefit agency MBS relative valuations. Over
the last two weeks of May, as rates rallied on fear of a global slowdown, volatility
percolated, causing agency MBS to give back about 19 basis points (bps) of relative
excess performance. In the end, the agency MBS basis closed on a down note, the
Bloomberg Barclays MBS Index underperformed Benchmark U.S. Treasuries by 5bps
in May. Year-to-date excess returns now stand at -27bps, while year to date total
returns are -1.00%.

The poor May performance was primarily reflected in the struggles of highercoupon,
conventional MBS. Fannie Mae 30yr (FNCL) higher coupons closed with
negative returns relative to U.S. Treasuries. FNCL 4.5s returned -19bps with FNCL
4s coming in at -7bps. While the yield curve was largely flat across the month
despite some fairly significant fluctuation, lower incoming mortgage rates negatively
impacted up-in-coupon coupon collateral. While part of the negative performance was due to higher coupons giving back previous relative
gains, the specter of lower mortgage rates going forward
undercut performance in the month of May. Lower coupons,
on the other hand, benefitted from both lower interest rates
and previous underperformance. FNCL 3s outperformed
benchmark Treasuries by 2bps in May, the only coupon to see
positive relative performance in FNCL collateral. Ginnie Mae
collateral performance was slightly better than conventional
MBS across the board despite the usual underperformance
when interest rates fall. Lower coupon Ginnie Mae 30yr
(G2SF) collateral outperformed benchmark U.S. Treasuries in
May, with even G2SF 4s outperforming by 3bps. Performance
was slightly better than conventional MBS in higher coupons
as well, where the negative impact of coming lower mortgage
rates was mitigated by continuing positive regulatory news.
G2SF 4.5s underperformed benchmark U.S. Treasuries by
11bps in May, outperforming conventional collateral and
only giving back some of the largely positive performance
thus far in 2018. While lower coupon MBS outperformed
higher coupon MBS in May, higher coupons have powerfully
outperformed year to date. Gradual balance sheet reduction
by the Federal Reserve has been part of the story, along with
mortgage rates that have inched higher thus far in 2018.
Furthermore, demand has shifted toward higher coupons as
fears that lower coupons might become orphaned has picked
up. Whether higher coupon MBS can continue to outperform
will be a key trend to watch as the calendar flips to the second
half of 2018.

A month rarely goes by anymore without the continuing
saga of higher coupon Ginnie Mae collateral writing another
chapter, and May was no different. After elevated high coupon
Ginnie Mae prepayment speeds caught the ire of multiple
U.S. Senators and Ginnie Mae alike in the fall of 2017,
there has been continuing movement toward reducing the
prepayment speeds of Veterans Affairs (VA) loans. In May, the
newest addition was the passage of banking reform legislation
signed by the President, which included a bill known as
the “Protecting Veterans from Predatory Lending Act.” The
passage of the legislation and announcement that Ginnie
Mae will be implementing all of the components immediately
should pay dividends for Ginnie Mae collateral. The new
rules require that new loans made to Veterans and their
families now be subject to a net benefit test, fee recoupment
rules, and new seasoning requirements. In concert with
Ginnie Mae’s ongoing efforts to keep individual servicers
from churning loans by removing them from multiple
servicer pools, it appears as though most of the necessary
hurdles have been cleared to seriously reduce the churning
of Veteran borrower’s loans. While G2/FN 4.5 swaps were
still negative at the end of May, continuing efforts to reduce
VA prepayments caused swaps to appreciate markedly over
the past eight months. The end result is that the prepayment
speeds on higher coupon Ginnie Mae collateral should
decrease significantly due to reduced prepayments on VA
collateral going forward.

The agency MBS basis has struggled year to date from both a
total and excess return perspective. While total returns have
been maligned by an overall market selloff, the continuing
widening of the agency MBS basis is important. Volatility has
picked up from the historically low levels seen late in 2017,
hindering agency MBS performance. Despite the increasing
gamma, volatility still remains low by historic standards,
which makes further escalation quite possible. With the
Federal Reserve running off the mortgage pools on its balance
sheet, there is a fairly widespread expectation that the removal
of the Fed as a buyer of agency MBS will increase volatility
further in the space. Meanwhile as markets move into the
latter phases of the credit cycle, it is very possible that both
rate and risk asset volatility may increase further. A move
toward historic averages would be a fairly substantial jump
for agency MBS valuations to absorb. Thus, the subdued
gamma environment that has permeated the market in the
post-crisis period may need to continue for agency MBS to
offer significant outperformance as the calendar flips to the
summer months.